How to choose the right type of entity for your needs.
Are you an entrepreneur with the next big thing in mind or have an idea that you feel has great potential? If you are, thinking of starting your own business, or have you recently started a business, congratulations! Being an entrepreneur is one of the most rewarding decisions you can make, both personally and financially.
As you enter this new world of business ownership, there will be a number of questions you need to answer to ensure you set yourself up for success. A major consideration is the type of business entity you want. You will need to consider which type of business entity best fits your goals. Your decision will be based for the most part on whether you are the sole owner, the size of your business, your management style, liability and tax implications, your ability to raise funds and costs, and filing and record-keeping requirements.
The most common types of business entities are:
- Sole Proprietorships
- Limited liability Companies
There are advantages and disadvantages to each type, and we are here to help guide you through those as you make your decision.
Being a sole proprietor means you are the sole owner and make all of the business decisions. A sole proprietorship is the simplest structure to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and the owner. The main advantage to a sole proprietorship is that there are also no formal filing procedures to start your business or organize a business entity. Your business income and expenses are included in your personal income tax return.
You will, however, still need to obtain proper licenses, permits, and insurance.
The main disadvantage, however, to a sole proprietorship is that you are personally liable for any liabilities of the business, and you are putting your personal assets at risk. In almost any business there is the potential for liability, whether it be a customer, employee, or vendor. You may also find it difficult to obtain loans or attract investors since lending sources and investors are cautious about dealing with sole proprietors because of a perceived lack of credibility. Generally, because of the advantages that other business structures provide (most importantly–liability protection), we do not recommend running a business as a Sole Proprietorship.
There are several types of partnerships, including General Partnerships, Limited Partnership, and Joint Ventures. Generally, a partnership is a single business where two or more individuals share ownership. With several owners, you may want a partnership where the partners manage the company and assume responsibility for its debts. In a limited partnership, the general partners manage the business while the limited partners are investors only.
An advantage to partnerships is that in a partnership, profits and losses pass through to the partners themselves. Each partner reports profits on his or her individual tax returns. The partnership’s income is listed on a separate form, though it pays no tax.
The biggest drawback is that partners are still generally personally liable for the business’ debts and liabilities unless they are a limited partner. It is advisable to draw up a written partnership agreement that details how the partnership will be managed and operated.
As LLCs provide the same benefits of partnerships in terms of flexibility in ownership and management structure and favorable “pass-through” taxation, and greater liability protections, Partnerships have largely gone out out vogue. Except in certain circumstances, an LLC or Corporate business structure is generally favored over a partnership.
Limited Liability Companies (LLCs)
If you are a sole owner or only have a few co-owners, we typically recommend forming an LLC. This is preferred to a sole proprietorship since your personal assets are protected, and you do not have to follow all other corporate formalities.
An LLC is a hybrid of a partnership and a corporation. Along with protecting your personal assets as in a corporation, you have the added benefit of “pass-through” taxation. Earnings and losses are passed through to the owners, who report them on their personal tax returns. You can have unlimited owners, and each can fully participate in the business operations. Members can be individuals, partnerships, or corporations who receive a percentage of ownership.
Although an LLC is not as formally managed as a corporation, you still need to do the following:
- File organizing documents with the Wisconsin Department of Financial Institutions
- Adopt an operating agreement
- Hold regular meetings and adopt resolutions for major business decisions
- Keep minutes of the meetings
- Keep a separate bank account–avoid co-mingling personal funds
- File appropriate taxes
- Be adequately capitalized
- Maintain adequate insurance
- Conduct all business in the name of the LLC
Should you plan on running a large company with multiple employees, then a corporation may be the way to go. Corporations are separate entities from their owners. Consequently, there are more tax requirements and regulations to follow as well as costs. Corporations are generally rigidly managed and must comply with formalities including:
- Regular meetings of the Board of Directors
- Keeping minutes of the meetings
- All material business decisions should be adopted in a board resolution
- Annual shareholder and director meetings
- Separate bank accounts–no commingling of funds
- Stock ledger
- Be adequately capitalized
- Maintain adequate insurance
- Shareholders should avoid personally guaranteeing payment of debts
The main attraction of a corporation is that its owners are not personally liable for the corporation’s debts and other liabilities. A corporation can raise money by selling stock and has an indefinite life span since shareholders can sell or bequeath their stock.
Corporations do have to adhere to strict accounting and tax preparation.
Corporations are subject to state and federal taxes. Unlike sole proprietors and partnerships, corporations pay income tax on their profits. In some cases, corporations are taxed twice – first, when the corporation makes a profit, and earnings to shareholders or dividends are again taxed at individual rates on their personal returns.
If you are an “S” corporation, you can be taxed as a partnership. You can also avoid double taxation by paying compensation or salaries to individual shareholders, as corporations do not pay tax on such earnings and can deduct payments as business expenses, so long as the salaries are considered reasonable. S-corporations are limited to 75 shareholders.
For any type of business entity you choose, be sure you have adequate liability insurance and legal formalities in place. Organizational structure is not a substitute for adequate insurance or proper legal planning. Under a business entity providing liability protection, an owner generally not face personal liability unless a plaintiff is able to “pierce the corporate veil” (i.e. hold owners of a business liable for the liabilities of the business). Generally, a court will not “pierce the corporate veil” unless certain circumstances exist, such as the existence of fraud or wrongdoing, failure to follow corporate formalities, failure to adequately capitalize the company, or failure to maintain adequate insurance. Maintaining adequate insurance and following legal formalities are essential to avoid personal liability.
In addition, a carefully negotiated and legally enforceable governing agreement is essential no matter which entity structure you choose any time you are entering into a business arrangement with another individual. Without these documents in place, your business will be at risk if your business relationship ever “goes south”, or if the unexpected occurs, such as death, divorce, or disability of a partner.
When considering which type of business entity, consult with an experienced business attorney so you can make an informed decision about which is best for you.